Update on market volatility: Covid-19 remains key
A plunge in oil prices has sent markets reeling, but the epidemic is still the main concern.
Following our recent update on the impact of Covid-19, equity markets have taken another sharp lurch lower as the number of new cases reported outside of China each day continues to surge. To make matters worse Saudi Arabia fired the first shots in a price war, sending oil prices down by more than a quarter. Given the rising tensions between Saudi Arabia and Russian ally Iran, there is also the possibility that a real war could ensue. Financial markets would then demand even more return for the risks.
The steep drop in oil prices (Brent Crude futures were trading around $36 per barrel at the time of writing, down from $45 Friday and from over $60 three months ago) makes it more likely that some oil producers will default on their debts. This is concerning because US oil producers have accounted for an outsized share of new credit extended over the last decade. Rising defaults could threaten the failure of banking institutions who may have become over-exposed (or, far more damaging, the perceived risk of it). Given roughly 13% of the US high yield bond index is made up of oil producers, there is also the risk that bond fund managers may need to “fire-sell” good assets if investors start to redeem funds.
This puts further upward pressure on ‘credit spreads’ – the premium all non-government borrowers must pay for funds, which were already spiking as a result of the panic. This tightening of financial conditions means lower economic growth, all other things being equal.
Some commentators fear another financial crisis. Financial crises are different to normal recessions: they tend to be deeper and with less of a V-shaped recovery. We do not think that a financial crisis is likely.
There is a deep literature on financial crises, and they almost invariably have common markers. They tend to be preceded by an extraordinarily rapid increase in leverage (of a speed that we have not seen over the last 10 years), often as a result of financial de-regulation (quite the opposite to today) and an overextension of credit to un-creditworthy borrowers as a result of imprudent lending standards, especially by weak banks with inadequate capital (again no systemic evidence of that today). Most are also associated with banks becoming dangerously exposed to a highly-levered asset class such as property, which is used in turn to collateralise yet more loans. Again there is little evidence of this today.
Of course, we are concerned about the ability of some companies to finance themselves should profits plunge for more than a couple of quarters, but as it stands interest coverage ratios (the ratio of annual profits to annual interest expense) are reasonable. The median US non-financial company has an interest coverage ratio of seven.
Offsetting some of the latest pressure on financial conditions, government bond yields also plunged Monday as central banks are expected to continue to loosen policy, with the US 10-year Treasury yield down more than a quarter point to a record low of 0.50%. The UK 10-year gilt yield is currently 0.1%.
Lower oil prices could provide a modest boost to consumers and firms via lower energy bills. But if they are unable to spend the effective increase in disposable incomes due to travel restrictions or supply-chain disruption, it may not provide much of a lift. Pleasingly the direct loss of employment from any disruption to the oil industry wouldn’t be significant. Just 0.2% of US employment is in oil & gas extraction or pipeline construction.
The big unknown
A plunge in oil prices has sent markets reeling, but the epidemic is still our main concern. It’s impossible for anyone to predict the virus’s course – there is an absence of conviction among medical experts, let alone investment professionals. We view the financial implications in terms of three broad scenarios: (i) Covid-19 and the associated disruption could be on the cusp of dissipating rapidly; (ii) it could continue to worsen into the second quarter, greatly disrupting profits before the world gets back to normal in the second half of the year; (iii) it may escalate into a full scale pandemic, with lasting economic effects into 2021.
As financial markets are probability-weighting machines, we are using a simple valuation framework to help us assess our three scenarios. These scenarios give us a best case, a worst case and something in the middle, so we can model the effects on equity prices, weight them by probability and add them together to compare this probability-weighted price to today's actual price.
Assigning an equal possibility to all three suggests that equity markets, as of the end of last week, were trading where they should – somewhere in the middle of the two extremes. We assign an equal weight to all three of these scenarios because it is the mathematical expression of "we don't know". This exercise – just one of many tools we are using to assess the situation – suggests that staying invested with a preference for more defensive factors within equity allocations makes sense.
But the same can’t be said for fixed income assets with equity-type risk, such as high-yielding bonds with a low credit rating, or emerging market debt. Even prior to the oil price drop, we thought high-yield bonds (bonds with poor – below investment grade – credit ratings) were substantially overpriced given the rising risk of defaults in the wake of the Covid-19 outbreak.
What we do know
China’s oppressive coping strategy really does seem to have beaten the virus. Daily new cases have slowed to a trickle. For the last two weeks, between 88% and 100% of new cases have been in Hubei province, where it all began. The mortality rate is starting to level off, the severity rate has plunged and the recovery rate has surged to 90% outside of Hubei (it’s 67% across China as a whole). But the daily change in new cases outside of China is rising exponentially. We focus on this metric because during the 2003 SARS outbreak the peak in new cases coincided with the trough in equities and other risk assets. This also bore out early last month when new Chinese cases peaked and markets thought we weren't going to see epidemics in other countries.
South Korea and Italy are of more immediate concern. Like China, they are supply chain linchpins. It's possible that the daily changes in new cases in Korea has peaked, but it is too early to say for sure. Japan, for all the press attention, is a non sequitur (at least on the official numbers). Looking at the percentage changes, Korea seems to be following the Chinese roadmap, even without the draconian lockdown, which is good news for now. But, again, we don’t know how it will develop from here.
In the last few days new cases in France, Spain and Germany have started to rise too. There is a risk that as virulence peaks in one country it springs up in another, preventing a market recovery for some time.
The risk of recession
In our last quarterly InvestmentUpdate in early January, we concluded that a bias toward companies with good quality earnings growth and a generally defensive positioning within equity allocations made sense amid slowing global growth. At the time, the turnaround in the leading indicators of economic activity was very tentative and we noted the risk that things could get worse before they got better. Our analysis suggested that 2018 and 2019’s policy easing across the world was not due to lift profits until the second quarter (it lifts equity valuations immediately, but takes a long time to feed through into real economic activity), and in the meantime the economy and financial markets were vulnerable to another setback.
The leading indicators continued to firm over the first quarter, but given the Covid-19 outbreaks we believe it makes sense to stick to the same defensive biases for now. Leading economic indicators are likely to lose momentum again and the recent underperformance of more economically sensitive sectors seems likely to continue. We believe investors will continue to pay up for quality businesses with good cash flow growth.
Stock market corrections greater than 15% are very rare outside of recession, so, as ever, it’s the risk of a US and global recession that we need to monitor most closely. Last week's falls in equity markets invited comparisons to October 2008, but it is important to remember that the US had already been in recession for 10 months back then. Today, the world is very much not in recession, while the probability of the US falling into recession in the next 12 months was negligible before Covid-19 struck, according to our analysis of the indicators we believe have the best predicting power. In January the global manufacturing PMI, a much-watched measure of business confidence, had returned to a nine-month high. Another important difference is that policymakers are on the front foot. Central banks are cutting rates, and not because they mistakenly set them too high to begin with. The Bank of England’s agents are co-ordinating liquidity with commercial banks to ensure that China-facing firms do not run into working capital problems. And the finance ministers of the world’s major economies are already discussing a co-ordinated fiscal policy response should a pandemic emerge.
The path to recession
The threat to economic growth from Covid-19 or government reactions to it comes via three main channels: (i) tourism, (ii) the supply chain, (iii) sentiment.
Many Chinese tourists have stopped departing from China. They make up more than 25% of all tourist arrivals in Hong Kong, Japan, South Korea, Vietnam and Thailand, so these countries are particularly vulnerable to this channel.
The supply chain is the bigger threat. That said, the PMI surveys conducted in mid-February – before the outbreak in Italy and Korea but when Chinese factories were still in mothballs – didn't report all that much of an increase in supplier delivery times. In fact in the US, supplier delivery times were actually improving. Anecdotally, Chinese factories are springing back to life, but some of the daily data disputes this. Coal consumption by the six major Chinese power suppliers is still 35% below where we would expect it to be at this time of year; Baidu's tracking data suggests many workers have not returned to the industrial cities from their rural New Year family get-togethers. Data from the service sector (the largest sector of the Chinese economy at around 45% of gross value added) looks better: property sales in Beijing were down 95% year-on-year in mid-February but in early March they were higher (i.e. missed activity is being recouped). Expressway traffic is also back to within a few percent of last year's norm. That said, there are also anecdotal reports of empty shopping malls: people are returning to work but not, perhaps, to their usual consumption habits.
South Korean and Italian disruption adds to supply chain pressure. Italy puts huge pressure on the European automotive ecosystem via MTA Advanced Automotive Solutions, which has plants in the quarantined zones. A 10-day shutdown of FCA, Renault, BMW and Peugeot's plants would shave off 0.6% from eurozone industrial production, according to Oxford Economics.
Sentiment is the greater threat
As it stands, sentiment is the greater threat. Declining sentiment not only derails consumption and investment directly, but can tighten financial conditions which could lead to weaker firms going bankrupt, as we discussed at the start of our note. Central bank action is designed to support sentiment (of course, it can't do anything to help immediate supply chain dislocation). While last week’s surprise 0.5% cut from the Federal Reserve was not met with much applause from equity markets, it is important to note that financial conditions haven't tightened by that much – they tightened far more in the 2015/16 growth scare – and are still looser today than they were a year ago. The market had anticipated the rate cuts, and credit spreads (the spread in yield between corporate and government bonds), which tend to go wider as the risk of defaults go up, were still relatively tight. Rathbones’ own gauge of financial stress was also lower than in 2015/16 (prior to Monday’s selloff), despite the spike in equity volatility.
Of course if Covid-19 causes a contraction in profits that lasts for more than two quarters, some weak companies may start to become insolvent. But debt servicing costs are very affordable.
In short, we see little evidence that a Covid-19-induced recession would trigger a financial crisis. Especially when we consider that monetary policy is currently set so loosely – most recessions, and especially financial crises, are triggered by a monetary policy mistake.
There is also some growing concern about rising unemployment. Staff lay-offs from airline companies have joined recent announcements by some financial services companies such as HSBC. We are monitoring the situation closely but will only react if this appears to be spreading to firms that aren’t suffering profound structural problems. So far, there is no evidence that the Covid-19 has produced significant layoffs in aggregate. US jobless claims increased by 3,000 to 216,000 last week, but this is still below 2019’s average of 216,500. Given the extreme skills shortages registered by many hiring surveys across the world, firms might actually hoard labour as they worry about their ability to re-recruit staff if the Covid-19 disruption proves to be relatively short-lived.
We’ll continue to monitor the situation with a particular focus on consumer confidence, credit markets, leading indicators of recession and the spread of Covid-19.
For many months now we have preferred ‘growth’ companies to ‘value’. Today’s ‘growth’ companies tend to be businesses that are less dependent on greater economic growth for making more money. ‘Value’ companies tend to be more exposed to the ebbs and flows of GDP growth.
Cash-flow growth remains a scarce commodity, and we believe that investors will continue to pay up for it. Indeed an index of ‘value’ stocks in the US has underperformed a ‘growth’ index by an extraordinary 18% since the beginning of the year (globally, ‘value’ has underperformed by 8%). A survey of the history of value versus growth performance does not paint a strong case for value. Buying companies with the “cheapest” valuations has tended to lose investors money consistently over the last 20 years, especially in the US where value has underperformed for decades.
We continue to focus on choosing quality, cash-compounding companies because we believe they have the greatest chance of surviving left-field events like we are now experiencing.